Stephen King: Fear of wage inflation may lead ECB to choke recovery

Wim Duisenberg and his colleagues see higher oil prices as a direct threat to price stability

Monday 6 May 2002 23:00 BST

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With interest rate duties to be done, a central banker's lot is not a happy one. W S Gilbert might have had more interest in the local constabulary, but the stresses and strains of modern central banking are not far removed. After all, central bankers are, in effect, economic policemen, making sure that rowdy behaviour – in the form of either rising or falling prices – is stamped out before too much damage is caused. The problem, of course, is working out when this kind of preventative action should be taken.

Central bankers are a nice enough bunch but, given that they're generally part of the economics profession, they don't always agree with one another. Within each central bank, this need not matter too much. After all, we know that Alan Greenspan tends to dominate his colleagues on the Federal Open Market Committee (FOMC). We also know and accept the bird-like qualities – from hawks through to doves – of members of the Bank of England's Monetary Policy Committee (MPC). The European Central Bank is, perhaps, a bit more opaque but, even there, at least a track record is beginning to be established.

A bigger problem lies in the potential inconsistencies between different central banks. We have already seen interest rate increases from the Swedes, the New Zealanders and the Canadians. The big question now being asked in financial markets is: "Who's next?" A supplementary question might be: "Why?"

There are three specific concerns. First, industrial activity appears to have turned around very quickly since the beginning of the year. Whether it is manufacturing in Massachusetts or technology from Tokyo, there have been welcome signs of an industrial renaissance. Second, higher oil prices since the end of last year could be regarded as a threat to price stability. Third, in some parts of the world, wage increases have come through rather more aggressively than the average central banker would like to see. This has been particularly true in Continental Europe, where the German metalworkers are striking for pay increases of about 4 per cent.

At this point, the cracks begin to appear in central bank thinking. How, for example, should a rise in oil price be treated? Most central bankers will have unhappy memories of the 1970s and, therefore, a natural response is to shout "inflation". On their own, however, it is difficult to regard higher oil prices as being part of a sustained inflationary process. Higher oil prices are simply an increase in the price of one good against all others. Imagine a world in which the inflation rate was permanently fixed at zero. In this world, higher oil prices would sap incomes, leading to lower spending on other goods and services. Their prices would, as a result, decline. The overall price level would remain unchanged and there would simply be a different set of relative prices within the economy.

The central bank concern about oil prices is, in effect, a worry that this relative price effect will not be allowed to operate. If there is resistance to higher oil prices in the form of wage demands or price stickiness, this could sow the seeds of some kind of wage-price spiral. It was precisely this kind of resistance – combined with a rather flaky approach by central banks and finance ministries – that led to many of the inflation problems in the 1970s.

Is there any evidence of resistance today? Not much in the UK, where wage pressures have been moderating a lot over the past year or so. Wage growth remained rather too high in the US through much of last year but, with the unemployment rate now up to 6 per cent, it is difficult to see how the US economy could generate an ongoing wage-price spiral.

In both cases, therefore, higher oil prices, by themselves, do not appear to present a strong case for higher interest rates. What about the impact of industrial rebound? In the US, the jury is still out. Some of the more recent indicators have been a bit on the weak side. As a result, it seems doubtful that the Fed will be in any rush to raise interest rates. Two or three months ago, the markets began to talk about an increase in Fed funds in May – in other words, this week – but that expectation has faded, with bets now on August or even later in the year. In support of this view, it looks as though the Fed regards higher oil prices more as a risk to recovery than as a threat to price stability.

For the UK, the situation is a bit more complicated. The housing market remains a thorn in the MPC's side. Although there have been no clear inflationary effects stemming from higher house prices, there are one or two worrying signs. In the short-term, the most obvious concern is the extent of equity withdrawal – borrowing against your newly inflated house value – to fund consumer spending. Against a background of industrial renaissance, that could lead to some form of inflationary overshoot 12 months down the road.

Even without a pick-up in inflation, however, there could be a case for raising interest rates. If low interest rates are causing an excessive build-up in household debt, consumers could eventually find themselves in trouble. Remember, in an era of low inflation, real debt levels tend to hang around for rather a long time: low inflation is, ultimately, no friend of the borrower. On this basis, debt-driven consumption today could lead to debt-burden recession in a few years' time. Put another way, higher interest rates today could be seen as a defence against both short-term inflation and long-term deflation.

That leaves the ECB. As my chart shows, the ECB has already established a hawkish track record when it comes to higher oil prices. During the last period of oil price increases in 1999 and 2000, the MPC and the Fed raised interest rates by 1 per cent and 1.75 per cent respectively. In contrast, the ECB pushed interest rates up by 2.25 per cent, even though economic growth was never that convincing.

The basis of the ECB's argument is straightforward. Unlike the Fed and the MPC, Wim Duisenberg and his colleagues see higher oil prices as a direct threat to price stability. They believe that a wage-price spiral is always lurking just around the corner, waiting to ensnare them and leaving them impotent in the face of inflationary wage demands. And, in one sense, they have a point. It seems remarkable that unions in Germany and elsewhere could be pushing for substantial wage increases when economic recovery is only just beginning.

Even here, though, I would argue that inflation is hardly the main concern. Back in 1994-95, Germany saw another big wage increase. Everyone cried "inflation" but the reality was very different. Yes, the wage increases came through. But in our newly competitive world, German companies were simply unable to pass on the wage increases in the form of higher prices. Profits fell, companies slashed investment, unemployment rose and, eventually, the Bundesbank cut interest rates.

So, if the ECB were to raise rates soon – as hinted by Wim Duisenberg last week – it could eventually be seen as a major error. These days, wage increases, like oil price increases, are more likely to damage profits than lead to a wage-price spiral. And lower profits, in turn, are likely to lead to lower investment and higher unemployment. Fear of a wage-price spiral could simply lead to excessively tight monetary policy, choking off recovery before it really gets going.